Is Chevron in Danger?

The year 2015 was a year of margin contrast in the oil and gas industry. While it was a terrible year for the upstream companies due to the sharp fall in crude oil and natural gas prices, it was a year of strong margins for the downstream companies like Valero (VLO) and Phillips 66 (PSX) for the same reason. The glut of crude bringing down input prices for these firms while continued stable demand for gasoline and diesel has led to better crack spreads.

The crack spread refers to the profit per barrel of oil that refiners earn from turning oil into finished products like gasoline, diesel, and jet fuel.

But that was the reality of the last year only. This year hasn’t started up that well for the downstream business of oil companies. While 2015 was a strong year for downstream operators, refiners could soon follow oil companies’ downward trajectory. The integrated oil companies like Chevron (CVX), which were happy to offset their upstream losses with their downstream profits, need to worry now. This need to worry has materialised because the upstream operations has had nothing profitable left for the operators since a long time now. On the other hand, the profitable crack spreads are drawing more refining capacity online and leading to more supply for many derivative oil products. As a result of this flocking at the downstream space, established refiners have their inventories soaring beyond the limits they could handle. Players are struggling to combat already high inventories of gasoline and other products by cutting production at key plants, but that effort is unlikely to help sustain cracking margins over the short term.

The refinery crack spreads are close to their 5 year lows in the US market. In March 2015, refinery crack spreads, a leading indicator of downstream profits, were as high as 33 %. Within one year, the crack spreads have dropped by almost two-third to 12 %. Margins in the Midwest region have already turned negative last week.

Chevron’s downstream segment:

Chevron’s downstream segment performed impeccably well last year as margins increased due to some aggressive cost cutting measures and low input costs. The segment margin increased more than $ 2.4 billion during the year. The downstream business produced strong financial performance underpinned by one of the best years ever in terms of facility utilization and reliability. However, the higher margins were primarily due to the advantage the company enjoyed through the earlier part of the year. In the fourth quarter, global refining margins dropped 34 %, negatively impacting Chevron's U.S. downstream earnings. A milder-than-expected winter hurt the demand for refining products such as diesel and heating oil. Still, the winter was severe enough to keep more cars off the road in the US resulting in an increase in gasoline inventories to 20 year highs.

But these factors can very well be classified as temporary as well as regional. The winter season is almost over. So the cars won’t remain off-road anymore increasing the demand for motor gasoline. Also the effect of low heating oil consumption won’t be seen in the warmer part of the year that is ahead. Further, gasoline demand in other big car markets like China is steadily rising which may easily offset the negative effects of the temporary slackness elsewhere in the world. Gasoline demand in China is expected to increase by 200,000 bpd in 2016 after rising 7 % in 2015. It is also projected that gasoline demand in China will grow at a compounded annual rate of 6.2 %.

Even in the US, gasoline consumption is expected to increase by 70,000 bpd (0.8 %) in 2016 by the Energy Information Administration, reaching a record level of 9.3 million bpd achieved nine years ago.

Also, the demand for other refinery products is expected to increase substantially to drive the margins high. In 2017, jet fuel consumption is projected to rise by 20,000 b/d (1.0 %). The forecast distillate consumption could grow by an average of 60,000 b/d (1.6%) per year over the next two years. The production cut by major refiners like Monroe Energy (10 %) and Valero Energy Corp (25 %) will also help in bringing down the stockpiles at the refineries. Hence, the slump in prices of these products is soon to get reversed as shown in the above figures.

We can also see that crude oil prices are not going to rise back at the same pace as the product prices are. Thus we should expect the margins at the downstream business widen again.

Therefore, Chevron is very well placed to take good advantage of an increase in refining margins, as it has increased its downstream capacity. The company is now the largest producer of base oils, products that have got great future prospects as shown below:

Additionally, the company is prepared to cater to the soaring gasoline demand in the Asia-Pacific region after upgrading its Singapore refinery by constructing a cogeneration plant and a gasoline desulfurization facility. This product dictates high margins which would bolster the overall downstream margins of the company.

Conclusion:

The concentration of refiners at the downstream business due to attractive margins led to overproduction of refining products. However, some seasonal factors in various parts of the world stopped the demand for these products from growing fast enough for last few months. As a result, the inventories at refineries all over the world built up to serious levels and the margins at the downstream are now approaching zero.

However, there are indicators strong enough to believe that downstream product prices will rise sooner and faster than those at upstream. Hence, the margins are bound to improve again in the short term. Therefore, Chevron’s new investments in the downstream business won’t go futile and will allow the company to benefit from an improvement in demand for refining products.